Australia and the Global Financial Crisis

Over the last few months I have written a lot about the global financial crisis. My posts have focused on specific events as news has broken, ranging from a programming bug by Moody’s to the enormous US bailout plan and Government guarantees from Ireland to Australia. Here I will instead take a broader perspective and provide an overview of how the crisis has unfolded and, more specifically, how Australia came to be caught up in the mess.

A year ago, many commentators were extolling the idea that Australia’s economy had “de-coupled” from the United States and Europe, and would continue to be powered by the rapid growth of China and other developing nations. Concerns about inflation meant that interest rates were rising and many felt Australia would escape the incipient economic slowdown in the developing world. Events have instead unfolded differently. The Federal Government has taken the extraordinary step of guaranteeing deposits held in all Australian banks, building societies and credit unions and the Reserve Bank of Australia has delivered an unexpected 1% cut in interest rates, citing heightened instability in financial markets and deteriorating prospects for global growth. This was an extraordinary turnaround. It is, of course, the result of Australia becoming ensnared in the global financial crisis that began in mid-2007 and has intensified ever since. But how and why did Australia get caught up in a mess that started with falling property prices in the US?

The crisis has unfolded in stages. First came the bursting of the housing bubble in the United States. This in turn led to a cycle in which the prices of many mortgage-backed securities plunged, triggering the liquidation of a number of hedge funds holding these securities, which in turn led to further collapses in security prices. Following this hedge fund liquidation phase, the focus of concern moved to banks. Banks were slow to admit to the extent of their exposure to mortgage-backed securities and related derivatives, which led to a breakdown of trust in the markets. Banks became extremely reluctant to lend to one another and, despite repeated efforts by central banks to inject large amounts of cash into the banking system, the result was a liquidity crisis. This phase of the crisis has been both longer and more severe than most observers expected and has resulted in sweeping changes to the US banking landscape through both mergers and collapses. While the United States has been at the epicentre, each phase of the crisis has been echoed in Australia.

Back in June 2005, The Economist published these prophetic words: “Never before have real house prices risen so fast, for so long, in so many countries. Property markets have been frothing from America, Britain and Australia to France, Spain and China. Rising property prices helped to prop up the world economy after the stock-market bubble burst in 2000. What if the housing boom now turns to bust?”. These frothy property prices were fuelled by a combination of low interest rates, loosening lending standards, growing consumer appetite for debt and extensive use of securitisation, which effectively allowed home buyers to access capital from all around the world.

It has been estimated that from 2004 to 2006, more than 20% of new US mortgages were taken out by “sub-prime” borrowers with poor credit histories and limited capacity to service their loans. These borrowers instead relied on ever rising property prices allowing them to sell for a profit or refinance their mortgages at a lower rate once they had accumulated more equity. Of course, once prices started to fall, these borrowers began to fall behind in their payments or simply to walk away from a debt now much larger than the diminished value of their home.

In some ways, things were not very different in Australia. Property prices rose at a similar rate to the United States (see Figure 1) and ever since 2002-03 the Australian household savings rate has been negative. Until very recently, borrowers also faced repeated interest rate rises on their growing debt. However, Australia’s sub-prime market was much smaller than the United States at only about 2% of mortgages and while the United States still has significant excess housing supply, Australia still faces a shortage of housing. As a result, despite rising delinquency rates, Australia has as yet escaped a vicious bursting of the housing bubble. Nevertheless, many commentators argue that significant risks remain for property prices in Australia.

Figure 1 – Property Price Indices*

When it came to the second phase of the crisis, Australia was not so lucky. Many investors held securities with direct exposure to the ailing US sub-prime mortgage-backed market. Two prominent casualties were high-yield funds managed by Basis Capital and Absolute Capital. Mortgage-backed securities that had been repackaged in the form of collateralised debt obligations (CDOs) had also been widely distributed to so-called middle market investors: local councils, universities, schools and hospitals. Non-bank mortgage lender RAMS also found itself in trouble. RAMS was heavily reliant on short-term funding, much of which it sourced from US investors who were no longer interested in purchasing asset-backed commercial paper regardless of whether the underlying mortgages were in the United States or elsewhere. Unable to fund itself, RAMS became the first Australian corporate victim to the financial crisis. Other non-bank mortgage lenders also came under pressure as global securitisation markets effectively shut down. The one bright spot was that, unlike European and US banks, Australian banks appeared to have minimal direct exposure to sub-prime mortgage-backed securities and their derivatives on their balance sheets.

As the crisis shifted into the liquidity phase, the impact on Australia intensified. Institutions that were heavily reliant on financing, particularly from offshore, found it more and more expensive to refinance maturing debts. Among the companies caught in the crunch were Centro, MFS, ABC Learning and Allco. Of course the biggest institutional borrowers in Australia are the banks. They had come to rely increasingly on offshore markets in order to fund Australia’s growing borrowing habits. By 2007, Australia’s net foreign debt exceeded $500 billion, representing more than 50% of the country’s annual gross domestic product. A significant proportion of this debt is raised by banks. Despite their relatively clean balance sheets, Australian banks were forced to pay the same high margins on their borrowings that investors were demanding of European and US banks. Even money markets in Australia were affected, pushing up the interest rates banks had to pay for short-dated borrowings. Like other central banks around the world, the Reserve Bank responded to the liquidity crisis by injecting additional cash into the system. As part of this effort, in September 2007 it significantly expanded the range of collateral it would accept from banks in exchange for funds, even going so far as to allow mortgage-backed securities, albeit highly-rated ones. Despite the global and local turmoil, the Reserve Bank remained concerned about inflation, raising rates four times during the credit crisis. In an effort to recoup some of their soaring funding costs, banks broke with tradition and raised mortgage rates over and above the Reserve Bank moves.

Figure 2 – Growth in Australian Foreign Debt*

Increased funding margins for Australian and international banks also led to a more general widening of credit spreads** outside the financial sector. This spread widening took its toll on the performance of Australian fixed income funds, which had traditionally invested in corporate bonds (particularly banks) as a means of enhancing portfolio yields. The stock market also began to suffer. Admidst the gloom, there were some periods of respite for investors. Spreads tightened and the equity market recovered some lost ground after the bailout of Bear Stearns in March 2008, but only until news of further write-downs and capital injections for Merrill Lynch, Citibank, HBOS and others further eroded market confidence.

Despite the funding challenges faced by the banks and the volatility in Australian fixed income and equity markets, it was not until September 2008 that alarm spread outside financial markets. As governments around the world began guaranteeing bank depositors, Australians began to realise that their own deposits were not guaranteed. This led to fears that Australian financial institutions, particularly regional banks and credit unions, could experience a run by depositors, something that none could withstand regardless of the underlying strength of their balance sheets. Fearing the catastrophic effect this could have on the Australian economy, the Federal Government swiftly moved from plans to guarantee sums of up to $20,000 to announcing on 12 October 2008 a comprehensive guarantee of all retail deposits for three years. At the same time, they announced a guarantee scheme for bank wholesale borrowing to ensure Australian banks could compete for funding against other Government-guaranteed banks around the world. Nevertheless, Australian banks still have had no need of the capital injections received by many banks around the world.

While moves by Governments and regulators around the world appear to have averted systemic financial failure, concerns remain about the impact the global financial crisis will have on the real economy. With tighter lending standards, weak consumer and business confidence and signs of slowing international demand for Australian commodities, Australia is unlikely to escape this phase of the financial crisis. The Government hopes that a $10.4 billion stimulus package will help protect Australia from the anticipated global recession, but few commentators still believe that Australia’s economy has “de-coupled” from the United States and rest of the developed world. Mind you, that is partly because Asia and developing nations around the world now seem well and truly coupled to the US-led financial crisis.

*Data sources: Australian Bureau of Statistics, Standard & Poor’s/Case-Schiller
**Credit spreads are the difference between interest rates that corporates pay on their bonds and benchmark interest rates (e.g. Government bond yields or swap rates).

From another big picture but different theme, I’m fascinated by the changing geopolitical situation. So much is happening that I can’t say I truly know how it’s going to turn out, but one thing that is certain our world is now changing structurally in a big way.

I’m wading into a global finance discussion here, which i’m patently unqualified to do, so go easy on me please.

Clearly the AU/US decoupling thesis was wrong, but i’m not sure that we’ve tested the strength of the AU/Sino relationship yet. I never really believed the ‘Chinese domestic spend will carry us thru’ line, but if the Chinese investement in US treasury continues to hold up, they will be able to finance moderate growth for quite some time, no?

@Dan: no qualifications required for comments here at the Mule! You do make a good point. I would say that the de-coupling idea creates something of a false dichotomy: either we are completely tied into the US or completely separated. Of course the reality is somewhere in between: we have direct and indirect connections to many countries, including China and the US. Since the US is a major export market for China, our connection to the China also creates an indirect connection to the US. A full decoupling theory would rely on China not being affected by economic effects in the US and Europe, but currents trends suggest that China and the rest of Asia are not immune.

De-coupled eh Mule. Well, I guess all those commentators are wittnessing first hand how we are about to be re-coupled. Had we done anything more sophisticated other than dig stuff out of the ground, admittitedly more efficiently, and ship it to China, the theory might have been somewhat more believable. Unfortunatley, it wasn’t much more than that. Funnily enough, we’ve had booms in commodity prices before and we’re about to see another one end.

@CV: once it was the sheep’s back. Now we’ve been riding on the back of metals, but it looks as though the ride is over. Does anyone have any coins to start it up again?

@Elias: you are right about the structural changes. While the severity of the crisis is such that Governments are right to be intervening, it is also no surprise that “policy on the run” and “unintended consequences” are well on their way to becoming cliches. For better or worse, the world is changing as we watch.

With my extremely unqualified knowledge, I would have thought that it was obvious in the lead up to the GFC, and should be even more so now, that the world’s economy is now truly globalised and interdependent, and that when a crisis emerges of the magnitude of the sub-prime clearly in a “lender state” (ie: a state in which IMF assistance is not possible) such as the US, that the entire world will be affected.

So while, say, Argentina in 2001 was not a major problem to the Australian economy in general, any US and European crises clearly would be.

It is all hindsight now, but am I crazy in thinking that this much (if not how to deal with it once acknowledged) should have been beyond question?

No doubt the next stage of discussions will revolve around a winding back of the current deregulation that has occured in recent decades. This has advantages and disadvantages but the rise and rise of derivatives have played a major part in the whole crisis.

One thing I do not agree with is your take on the Aussie Property market, there is no shortage here and Aussie banks are extremely vunerable to a down turn in property. Aussie banks have already started to raise capital and it is only a matter of time before they will need to raise again. You need to look at the combined Aussie home loan book which is about I trillion dollars. One in five aussies are undergoing mortgage stress that’s 200 billion dollars. The combined profits of the banks in the best times was 15 billion, that leaves no margin for error. This blind faith in the inflated value of a block of sand in this country astounds me!

@Clive: I don’t disagree with you that there is significant risk in the Australian property market. As the first chart indicates, there has been a significant run up in property prices in the Australian market in the last few years and, in terms of affordability, prices are looking expensive by historical standards.

Affordability is a good way to look at the true cost of housing and seen in this light there are three things that can improve affordability: inflation (via the associated increase in wages), falling interest rates and falling house prices. Inflation is rapidly diminishing, so will not help. Interest rates are flling, but probably not enough to prevent continued decline in house prices. In my view, house prices will continue to fall into 2009, but the fact that we don’t have the same enormous overhang of supply as the US means that the fall is unlikely to be as severe as seen over there. Also, as I noted in the post, there has been less “sub-prime” lending in Australia so a decline in the housing market will not translate into delinquencies and defaults at anything like the rate of the US (or the UK for that matter). Still, as you say there is already significant mortgage stress in parts of Australia and I expect that 2009 will be the worst year for mortgage lending losses that we’ve seen in a long time.

The situation for mortgages in Australia is much like the picture for the economy as a whole. It will be ugly, but we are somewhat better placed than other developed countries so, as bad as it will be, our experience will probably not be as bad as elsewhere.

I like this blog. I’m new to the blogging world but I like hearing perspectives from other countries than the US. Like my blog is not so much about the news but more or less I try to capture the general feelings of the community from the Canadian capital. http://tchernahofsky.blogspot.com/
Good stuff.

The problem is to far spread the retarded socialist government keep giving the the money out to the people who won’t spend it in fear that they will will need when it was given out for those people to spend. The government needs to earn back the trust of the people and help get us out this crisis, the morons who voted in a socialist government look at what you’ve helped get Australia into.

And who ever’s idea at the top to take money out of the econemy by lowering interest rates need by fired. Just making matters worse 1% to the individuals is nothing compared to a national 1% that would help.

The banks also retarded, not thinking ahead, lending out so much money to people with shady credit histories and not being able to get repayments because they did not forsee those people not be able to pay back.

@Tim: Am I correct in assuming that the “Socialist Government” you refer to is the Rudd Government? If so, I think you’re characterising them as far further left of centre than they really are. Also, the roots of the current problems that Australia is facing predate the Rudd Government (although, if Labor had been in power earlier, I don’t think they would have done anything to prevent the problem). The crisis is partly imported, partly home-grown. I agree that inappropriate lending was a big part of the problem, for which banks should take some blame, as well as consumers hooked on credit. However, voting for the Rudd Government was not the cause of the crisis.

Also, one quick technical point. The aim of lowering interest rates is to pump more money into the economy, not to take it out.

What i dont understand is the stimulus packages coming out now. Surely the sudden injection into the economy will be seen by investors and retailers (the main recipients of the flow on cash) will be seen as superficial, despite the multiplier effect which will, admittedly, could possibly significantly stimulate the economy.

I would see it more a case of common sense that the government take this crisis as a chance to make us less independent of imports. Create new jobs through govt companies working for the government!!

Alot of the recent “news worthy” layoffs (ie. pacific brands) could be re-employed by the businesses in making, oh i dont know, the uniforms of all the public service employees, contracts supplied to australia’s boat industries to build patrol boats, which will become increasingly important in our region, the various equipments used by our defence forces etc. Take this chance to solidify our independence of imports from america, china etc. for the very supplies we need.

@kelly: I do think that the experience of the financial crisis supports changes to regulations.

Banks are a bit different to other businesses as they form part of the mechanics for the operation of our economy. If, say, a textile firm went out of business it may be a shame and society may want to provide some kind of assistance, financial or otherwise, to workers who have lost their job. But the failure does not threaten the broader economy. The same is not always true of banks, particularly if they are large or a number are threatened at once, as we have seen recently. In this case failure could have far broader repercussions. This has been understood for a long time, which is why banking is already subject to extensive regulation. But the regulation of banks is effectively an ongoing experiment. The rules are designed based on problems or near misses that have been observed over the years. The latest crisis show that we have not yet got the mix quite right. Two key lessons are the importance of preventing individual banks from becoming “too big to fail”. First, since it will never be possible to completely eliminate risk, we should at least have an environment where a single institution could be allowed to fail, like a textile firm or any other sort of business, without threatening the whole system. Second, it has become evident that it is not only traditional retail and commercial deposit-taking banks whose failure can threaten the economy. The same can be true of the so-called “shadow banking system”, comprising businesses such as investment banks, hedge funds and the like. Changes to regulation should therefore extend greater restrictions on the activities of these sorts of firms.

Even so, the new regulations will, of course, not be perfect. But they will, with luck, represent an improvement in this ongoing experiment.

This is an opportunity for australia not to be missed. Our banks are in the top 20 of the world most financially sound banks, there is a definite lack of investment everywhere (bar for government investment) so why not take this opportunity to turn around our high CAD (current account deficit)? Lets reverse the trend of more investment coming into australia than is going out. Decrease our net foreign debt and equity by increasing the inflow of funds to australia through profits and debt repayments. Avoid the debt trap we are inevitably moving towards while we still can.

The financial giant that is america has been momentarily staggered, lets take advantage while we still can.

@Tom: it does depend on how you measure the top 20 banks, but I take your point. The current crisis creates all sorts of opportunities. Fortune favours the brave, but I’m not sure how many are brave enough to take this opportunity!

There was an effect for small businesses: bank credit was harder to come by and more expensive for a while. However, since Australia has managed to bounce back to growth in a way the few other developed countries around the world have managed, the effect on small business here is starting to look fairly mild compared to businesses in the US, UK and elsewhere.

Australia was always going to be better placed in the face if the GFC than many other countries: resources exports to China helped prop up the economy and our banks had much healthier balance sheets (very little in the way of “toxic assets”). Still, the government did respond with stimulus spending (like the $900 “flat screen” windfall for taxpayers) and provided a government guarantee for the banks: although their assets were pretty good, they still depended a lot of international wholesale markets for funding and no-one wanted to see a run on a bank.

@Anna: part of the explanation is that during this time, consumer debt was growing rapidly in Australia. Australian banks had no shortage of lending opportunities. Locally there was growth in “low doc” lending (not quite the equivalent of sub-prime) and, to a much lesser extent “non-conforming” lending (more like the equivalent of sub-prime). The banks did not really get into non-conforming, that was largely the domain of some non-bank lenders (funded by securitisation). While delinquency and default rates have been higher for low doc than regular mortgages, losses on these mortgages in Australia have remained very low.

By contrast, a number of European banks were keen to fund new assets before the crisis and securitised mortgages from the US were one source of assets. As a result, outside the US there were far more European banks with exposure to US sub-prime than in Australia.

There were some smaller investors (e.g. councils) in Australia who suffered some losses from investing in structured credit.